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April 18, 2016 at 06:07 AM
A few weeks ago, we compared a traditional IRA to a Roth IRA in our weekly blog. While there are a number of factors that influence this decision, our focus is primarily on the tax effect. In this post, we will continue our discussion.
(If you missed the first two parts, you may want to read them first: Traditional IRA vs. Roth IRA: What’s Best? and Traditional IRA vs. Roth IRA: What’s Best? Pt. 2—The Details)
Congress and the Roth IRA
In 1997, Congress unveiled the Roth IRA as an alternative to the traditional IRA. The tax-free withdrawal aspect of the Roth, plus the ability to convert a traditional IRA to a Roth IRA and spread the tax liability over a four-year period, was quite appealing to many investors.
I suspect Congress created the Roth IRA to increase tax revenue as people converted their traditional IRAs to a Roth. In addition, since contributions to a Roth are after-tax dollars, it makes sense that tax deductions would decrease, again, boosting tax revenue.
Which is better: the Roth or the traditional IRA? I used to believe the Roth was best, especially for younger investors. After a thorough examination, I have a very different opinion.
The Analysis
The table below contains a recap of the major assumptions during the contribution and withdrawal phase (25 years each – 50 years total). The analysis assumes the investor begins with $10,000 before taxes.
In the chart that follows the table, in the traditional IRA (blue line), the entire $10,000 is invested each year (pre-tax) and withdrawals are increased to $13,889 to provide $10,000 after tax. Roth-1 (black line) assumes there are no taxes during the contribution phase and the full $10,000 is invested each year. Roth-2 (purple line) assumes a 28.0% combined tax rate during the contribution phase, thus reducing annual contributions to $7,200. Finally, even though this taxpayer’s income will prohibit a Roth contribution, Roth-3 (red line) assumes a 38.9% combined tax rate during the contribution phase, reducing the annual investment to $6,110.
In all Roth scenarios, since qualified withdrawals are income tax free, the total annual withdrawal is $10,000. In short, the traditional IRA has the advantage over Roth-2 and Roth-3 during the contribution phase and all Roth IRAs have the advantage during the withdrawal phase.
